The US equity rally has now erased most of the August correction. That American equities are looking beyond weakness in emerging economies is not much of a surprise.
Some of the reasons include the fact that developed world banks are less on the hook than in previous emerging market (EM) crises. Risks lie more with bondholders and portfolio investors, some EM countries have greater foreign exchange reserves or are more reliant on domestic rather than external debt, and there is a significant US$600 billion wealth transfer to developed world oil consumers from producers, in the form of a long-term pay-off from lower energy prices.
US equities are also looking past a US economy operating on one leg (services, but not manufacturing), a large inventory overhang and a slower than expected S&P 500 earnings season in the third quarter. We believe that the domestic side of the economy will hold up. Our baseline view is for a renewed dollar appreciation, weighing on net exports and steering headline GDP growth towards between 2 and 2.5 per cent for the year. We view the Federal Reserve’s Federal Open Market Committee (FOMC) statement at the end of last month as decidedly hawkish. Furthermore, the last October payroll numbers, released in the first week of this month, were also supportive of our call for the Fed to raise interest rates at the FOMC meeting on December 15 and 16. The market’s estimate of the probability of the Fed increasing next month is now about 65 per cent. Our assessment of a potential lift-off is higher than that, and we expect Fed communication to continue to move the market’s probability higher in the weeks ahead.
The last missing piece of the puzzle is some clarity on inflation and whether continued wage growth will induce a gradual pick-up in core inflation in the way the Fed expects. The increase in average hourly earnings in the latest job numbers is supportive of the Fed’s stance on lifting inflation. Incoming data on survey-based measures of inflation expectations will be important to watch.
Lastly, our call for lift-off in December is not a change in the slope of the Fed’s longer-term upwards path, which we expect to be very gradual given the still high levels of slack and underemployment in the labour market. We look for the Fed funds rate to settle at about 1 per cent by the end of next year.
As things stand now, global equities are generating the kind of returns this year that one would expect in an environment of low earnings growth, developed world equity valuations that are above median and weak commodity prices. Therefore, our expectations for next year include mid single-digit returns on US equities and similar returns in Europe after adjusting for the decline of the euro. We continue to be negative on commodity-related equities (in certain EM countries, Canada and Australia) and expect positive returns in Japanese companies that are more related to government intervention in equity markets. Finally, we expect weak returns in EM manufacturing countries reliant on Chinese growth.
Markets aside, we note that macroeconomic and geopolitical risks look to be rising. Not only are Spanish elections taking place before the end of the year, but we also have presidential elections in the US next year as central bank policy divergence increases across developed economies. We believe that these events may temporarily affect the price of all risk assets. That means higher volatility, greater sector and security dispersion and, on the margin, a little less certainty for the first half of 2016.
Cesar Perez is the global head of investment strategy at JP Morgan Private Bank.
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